Second, the explanation incorrectly assumes the entire U.S. economy is on a deleveraging cycle….[The balance sheet recession view] fails to recognize that for every debtor there must be a creditor. Thus, for every debtor who is cutting back on spending in order to pay off his debts, there is a creditor receiving money payments. In principle, these creditors should be increasing their money spending to offset the decline in money spending by the debtors — but if that were happening, there would have been no decline in overall total current-dollar spending. Instead, creditors are sitting on their money because they see an uncertain economic future…

If these creditor households, firms, and banks all simultaneously started spending their excess money balances, this would increase total current-dollar spending and in turn spur a real economic recovery. Moreover, knowing that the real economy would improve would feed back and reinforce current spending decisions by the creditors — creditor households would buy new cars and remodel their kitchens, creditor firms would build new plants, and creditor banks would increase lending. A virtuous cycle would take hold and push the economy back toward full employment. But this virtuous cycle is not taking off because creditors are still hanging on to their money balances. What is needed to kickstart this cycle is an entity powerful enough to incentivize all the creditor households and firms to start spending their money simultaneously.

Enter the Federal Reserve. It alone has the ability to provide these incentives through its control of monetary policy. The fact that total current-dollar spending has remained depressed for so long means that the Federal Reserve has failed to do its job and effectively has kept monetary policy too tight.

“why aren’t the creditors who are receiving the increased payments spending the money?”

There’s no reason to expect them to spend it, because it’s not income; it’s just a return of captial. The question would be, “Why aren’t they re-lending it?” The reason they aren’t re-lending it is that, with debtors trying to pay down their loans, the demand for loans is too low to produce high enough interest rates to justify the risk. You can call it an excess money demand problem, but the excess money demand is a result of the balance sheet problem, because money happens to be an asset that becomes attractive when loan demand is weak.

There are two things going on. The first is whether or not we are on a deleveraging cycle and the consequences of this; the second is whether or not fiscal and/or monetary policy can impact deleveraging.

The economy is deleveraging; that’s not being made up. The Federal Reserve’s latest quarterly Fed Flow of Funds last week, and consumers continue to delever:

What are the consequences of this? I want to recommend this excellent presentation (pdf) by Karen Dynan of Brookings, who walks through likely consumer spending scenarios related to consumer deleveraging. She finds that there is more deleveraging to come. It certainly looks like consumers are develeraging too fast for it to just be from households paying down debt, and Dynan finds that a large majority of the deleveraging is coming from bad debt being written off.

When there’s a charge-off event two things happen relevant for whether or not the money is relent. The first is that the borrow signals he or she is a credit risk, which will reduce access to credit. The second is that the lender’s probability of financial distress goes up, so they want to be more restrictive in how they lend; they have suddenly gotten themselves in the real estate business through replacing a debt assets with an abandoned home in a flooded market. This is the opposite problem of someone saving too much and signaling that they are a better credit risk and someone having too much to lend.

I think the spillover effects from foreclosures, abandoned properties, limbo REO houses, etc. are real and have consequences for consumer spending, borrowing and investments in neighborhoods. That at least some, if not many, of these foreclosures are the result of a broken too-thin servicer model is one reason this blog spends so much time arguing for moving foreclosure negotiations from servicers to bankruptcy judges. We can fix a lot of this with a Chapter M for Mortgage expedited bankruptcy process (and some inflation).

Sometimes people float the argument that the mass foreclosure waves should boost consumer spending power, since people are getting free rent. I think that overestimates how many people are staying in their house once foreclosure starts. There’s evidence that many people who are delinquent on a first mortgage are still paying junior lien claims. And if you are losing your home often you have had an unemployment spell; it’s not clear that you’ve boosted income.

There’s other criticisms of this approach. JW Mason has written that we must remember that claims that fiscal consolidation will reduce aggregate income are an empirical claims, ones that are likely true but ones we shouldn’t take for granted.

I don’t deny there is deleveraging, I just think it is better framed as an excess money demand problem. Here is why.

First, saying the entire economy is deleveraging misses the debtor-creditor distinction outlined above. Sometimes the creditor role is hard to see, but it is always there causing the excess money demand problem. For example, if a bank loan is paid down both loans and deposits fall. If those deposits were checkable, saving, small time, or money market accounts–assets used as money–the money supply falls too. For a given demand for money, this drop in the money supply now means we have an excess money demand problem.

Second, I would argue that contrary to Andy’s claim causality initially runs the other way: a spike in money demand causes the economic problems that create the balance sheet problems. I believe balances sheets would be in far better position had the Fed stabilized nominal expectations in 2008 and prevented the collapse in 2008. Like Scott Sumner, I believe monetary policy was tight by mid-2008 making the financial system more susceptible to what unfolded later in the year. Given the realization of the financial crisis in late 2008, the Fed still should have more aggressive in stabilizing nominal expectations afterward. Had the Fed done all of this it would have been fixing the excess money demand problem.

This balance sheet recession vs. excess money demand problem is closely related to the paradox of thrift idea that I also think is just a special case of an excess money demand problem.

I don’t entirely disagree with what David Beckworth says in the comment above. The Fed was too tight in 2008, and that excessive tightness was at least partly responsible for the balance sheet problems. But one can’t reasonably expect the Fed to get everything right. In this case, the Fed’s misjudgment had particularly disastrous consequences because of (1) the precarious state of balance sheets at the time and (2) the zero interest rate constraint. Being more interested in macroeconomics than in financial regulation, I tend to focus on the latter, which it seems to me could have been prevented (or at least minimized in impact) by targeting a higher inflation rate in the first place, but somehow that lesson doesn’t seem to have been learned. As for excess money demand, I used to think that I knew what it meant and that it was reasonable to frame macroeconomic issues in that way, but my recent thinking has become increasingly skeptical of the whole concept of money.

“Second, the explanation incorrectly assumes the entire U.S. economy is on a deleveraging cycle….[The balance sheet recession view] fails to recognize that for every debtor there must be a creditor. Thus, for every debtor who is cutting back on spending in order to pay off his debts, there is a creditor receiving money payments. In principle, these creditors should be increasing their money spending to offset the decline in money spending by the debtors — but if that were happening, there would have been no decline in overall total current-dollar spending. Instead, creditors are sitting on their money because they see an uncertain economic future…”

I don’t think this is true at all. The interaction between a lender and borrower can very much be a negative sum game, where the borrowers inability to repay hurts both parties. The problem is not just that borrowers are spending money paying down debt which they would have previously used to buy commercial goods, it is that they cannot repay their creditors either.

As for the second paragraph, it is not even remotely the case that forcing those with “excess money balances” (what does excess even mean in this context?) to spend will spur a real economic recovery. Beckworth is assuming that the spending which these creditor households will be forced to undertake will be productive and provide a positive return on investment- which won’t be the case if they use their money to remodel their kitchen and buy a new sportscar. The entire notion that a large amount of sudden spending can “jump-start the economy” falls apart when you allow for this possibility.

One aspect that seems to be little covered here is the effect of homeowners that *can* make their monthly payments, but that are so far underwater that it makes no financial sense to do so.

There are over 11M home with underwater mortgages. Of these, at least 5M have an LTV of 125% or higher, and these 5M mortgages have an average negative position of $130K underwater.

There is an interesting graphic produced by the New Your Times based on CoreLogic data[1] which shows that at best, 9% of the mortgages on homes with an initial value less than $1M are in default.

This implies that something like 4.5 million households are servicing mortgages that are severely underwater.

These would be 4.5 million of the very best economic players in the U.S. economy who are hopelessly trying to fill a $130K hole with the meager allocation of principal payment contained in each monthly mortgage payment.

As Mike’s referenced article points out, “for every debtor …, there is a creditor.” As much as the homeowner is frozen out of the economy due to their insistence on not renegotiating a financially irrational contract, there is an equal and equally frozen ability to lend on the other side. It may have been sliced deli thin and collateralized across the globe, but the net effect is indisputable. There is $1.9T of the very best economic players sidelined, and an equal $1.9T of lending capacity that is not transferable, and equally sidelined.

Most all of the attention so far has been on how to help the tiny fraction of borrowers who do not have the financial ability to service their existing mortgage obligation.

It seems to me the attention should be on the 90% that can service their underwater mortgages. That is the real elephant in the room. Until a solution addresses borrowers that are not struggling to make their payments, the housing market will remain moribund, and the almost $4T in real economic capacity will remain frozen.

To tie this into the deleveraging theme… The $1.9T of severely negative equity mortgages are backed by $1.2T of prperty at FMV. The means $744B of deleveraging should free up $1.9T of economic capacity. Twice. Until something lets 700 odd billion dollars out of the U.S. mortgage portfolio, it’s hard to see how things move.